Poor economic growth prospects, high unemployment, large debt burdens, poor public finances – it is all too easy for analysts and economists to say that the euro won’t be around indefinitely. Yet here we are, coming up to the five year anniversary of the Lehman Brothers collapse and having lived through a number of sovereign debt crises, and the euro remains the single currency for the Economic and Monetary Union (EMU) after being established in 1999. Many will argue, as we have in the past, that a monetary union is unsustainable without a full and proper fiscal union and that to devalue internally through lower unit labour costs is too painful for countries like Ireland and Greece. This would likely result in a divergence of growth within the Eurozone. However, we have to acknowledge that the European Union members and European Central Bank have done a remarkable job of managing the short-term symptoms of the crisis and have met every challenge that having the monetary union in place has produced so far.
That said, the long-term challenge remains: convergence amongst the Eurozone members so that a single monetary policy based on some level of price stability is as relevant for Germany as it is for Greece. The difficulty in achieving this convergence is the main challenge facing the EMU today due to the difficulties in operating under a single monetary policy and a single exchange rate.
With this in mind, now is a good time to think about whether the most ambitious currency union in history has the legs to go the distance after all. What are the main reasons why the euro will survive and prosper in the future?
Leading indicators like the PMIs and industrial production are pointing toward positive growth in Q2. Consumer confidence is improving, while unemployment numbers are starting to slowly improve in some countries as well. Of course, Europe is not yet out of the woods and continues to face significant growth headwinds which we have written about before. Nonetheless, it may be that we are witnessing the some early signs that the substantial structural reforms in the periphery are starting to bear some fruit.
Importantly, the Eurozone is showing signs of rebalancing. Unit labour costs (ULC) rose too quickly during the boom years in peripheral Europe and in Germany they did not increase enough. This eventually resulted in a large difference in competitiveness within the Eurozone which has started to dissipate (though countries like Italy and France still have further work to do – see our blog here). Turning to current account balances, Italy and Ireland are running a surplus, Greece has reduced its large deficit and Spain and Portugal are running small deficits.
These are small, but necessary, steps toward ensuring the survival of the euro.
In contrast to the southern European countries and Ireland, Germany has experienced an economic boom. Unemployment is low, exports are strong, inflation is low, the consumer sector is vibrant and we are starting to see some signs of house price appreciation in parts of Germany. A large reason Germany has done so well during the period of turmoil is because its external competitiveness has not been offset by a rising currency. For example, Germany’s real exchange rate under the euro is around 40 per cent below where the deutschemark used to trade against the US dollar.
Germany is operating as the China of Europe (at least from a trade surplus perspective) – a massively undervalued exchange rate is generating the world’s largest trade surplus of around €193bn a year (China’s is running at around 150bn USD a year). This surplus is overwhelmingly being generated through trade with other Eurozone members (like Italy, Greece, Spain, Portugal and Ireland).
The surplus capital that Germany’s improved international competitiveness generated has found its way into southern Europe and Ireland. German banks and investors were part of the international community that lent to the respective governments and businesses of the peripheral countries in search of higher yields than their own German bunds were offering. Of course, if this capital had not been provided, the southern European countries and Ireland would not have had the ability to build up so much debt (in 2008, around 80% of Greek, Irish and Portuguese government bonds were owned by foreign investors). Additionally, ULC growth could have been more constrained in these countries (particularly in the public sector) and the gulf in competitiveness between Germany and the peripheral countries would be less pronounced than it is today.
Germany has been the greatest beneficiary of the common currency. Any default would devastate its banking system and export industry. Germany is on the hook, so it is very difficult to see why it would abandon the euro.
Germany currently benefits to a much larger degree from the euro than the heavily indebted countries. This is because the single currency has robbed these nations of the ability to become more competitive through currency devaluation (compare the experience of these countries against the UK for example). Additionally, interest rates are way too restrictive and deflationary forces have taken hold due to excess capacity and ultra high unemployment rates. Countries like Greece and Ireland have not had a recession, they have had a depression.
Because policy makers in southern Europe and Ireland have no access to the monetary policy or the currency lever, there remains only one possibility to gain competitiveness – painful austerity and internal devaluation through reduced wages. This is the only way that these countries can hope to compete with the likes of Germany in the globalised environment.
So why doesn’t a country leave? Greece, Ireland and Cyprus have severely tested the euro in recent years yet remain in the union. The strongest argument that has been put forward is that the costs of leaving the EMU will be too painful relative to the gains. Capital outflows, skyrocketing inflation, bankruptcy on a national scale, mass unemployment and social unrest do not make the option particularly enticing. And just imagine what will happen if Italy or Spain decide to get out. To retain the euro is the least worst option for the debtor countries.
It has now been a year since ECB President Mario Draghi delivered one of the most important speeches in the history of Europe and stated: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” In stating these remarks, Draghi convinced the markets that the ECB had unlimited firepower to support its members and more specifically, Spain and Italy. Immediately, yields on peripheral European sovereign bonds fell from dangerously high levels that made borrowing unsustainable over the long term and are currently much lower than their levels a year ago. It is fair to say the market still believes Draghi and is now pricing risks more appropriately. With the ECB taking tentative steps towards forward guidance, it may not be long before we see further unconventional monetary policy measures like a new LTRO announcement.
Despite the problems – the concerning outlook, the record levels of unemployment and debt, the proposed tax on savers in Cyprus – no country has left the EMU. The EMU has in fact added new members (Slovakia in 2009 and Estonia in 2011) and may add more (Latvia in 2014). European countries remain open for trade, have continued to enforce EU policies and have not resorted to protectionist policies. EU banking regulation has become stronger, the financial system has stabilised, and new bank capital requirements are in place.
It is true that Europe remains a huge concern for us. A successful monetary union requires not only political but also economic integration. European politicians must accept greater limits on their policy autonomy and this will be difficult to gain. Economic convergence is necessary. Perhaps most worryingly, a cocktail of lower domestic demand, austerity, reduced wages and high unemployment is normally politically costly and breeds social unrest. However, given the track record that the EU and ECB has shown and for the reasons listed above, perhaps the euro may be around much longer than some economic commentators currently expect.